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Page 1 of 5 When the duck quacks …. One of my favorite books about investing was written many years ago. It is called “Reminiscences of a Stock Operator” by Edwin Lefevre and although it was written in 1923 much of it still applies today. In particular, the concept of “Feed the ducks, when the ducks are quacking” is a classic piece of wisdom. My children have a favorite stuffed toy. It is a duck which they affectionately call “the duckquacker”. Many times we have left the duckquacker behind on our travels but he has always eventually been returned to our home. Whenever I see the duckquacker, it always reminds me of those timeless words of wisdom about investing. This week we had a very good example of feeding the ducks with the IPO of Blackstone, a private equity group. With any marketing exercise, it is important to judge demand and take advantage of an opportune time. Private equity has had the run of a lifetime over the past few years and who would know that better than Blackstone’s partners. At the same time, we have recently seen a backup in yields ending a 20 year bull market in bonds. What could be a more opportune time to offload expensive paper that depends on free (or cheap) money, hence the Blackstone IPO. I can’t imagine that such bright lights of the investment business would be selling out at the bottom of a cycle and so, it is very important to note that they are cashing in some chips, even if they aren’t selling out. The top of private equity, I ask? If not the top, then certainly a pivotal point. More importantly, is the change in direction of bond yields. Since 1987, bond yields have been in decline. Most people working in the investment business today have not experienced anything except a bull market in bonds. After the crash of 87 the Fed began its cycle of flooding liquidity into the markets to save us from a depression. In the following years it did so on several occasions: after the crash of 87, after the Mexican Crisis (95), after the Russian Crisis and Thai Crisis (97) as well as after the Long Term Capital Management crisis (98). These injections of liquidity can be clearly seen on a chart of bond yields as the yields fall back down from pushing on the top of the downward channel. But until now they never backed up completely; they returned to their comfortable downward trend, ensuring the biggest bull markets of all times. The first time the Fed started to raise rates after it flooded the system with liquidity (because of the banking crisis in 1990 and the first Iraqi War) I was on a plane coming back from Malaysia (where I saw firsthand a bubble in the making – more about that in another blog – see Chinese bubble tea). I anticipated getting back into the office to find my emerging market portfolio devastated by the rise in rates. Not so, not at all – to my amazement Latin American stocks kept going up. And up, for the next 8 months. In a dreamlike state everything stayed the same - Latin American companies raised money in the market, and we all went along like nothing had changed. Then in December, the Mexican crisis hit. It was like watching a movie in slow motion. The reason I’m writing about this is because I believe that we are going through an even bigger adjustment now. But it will be awhile until reality sets in as it always is, but one thing is for sure, smart money will take their chips off the table ala Blackstone. And they will want you to buy it off of them, so make sure you say no. An example of just how ludicrous things are right now: I was reading yesterday that Colombia has nominal interest rates lower than New Zealand and Australia. Colombia is a country, although resource rich still has a few minor problems like terrorism and instability. Minor problems to be sure, but problems nonetheless. Mexico as well has lower nominal rates lower New Zealand and Australia. I always think that countries with problems should have cheaper assets and until recently that was the case, but no more. But let’s get back to rising rates. The most important thing that rising rates does, is re-price risk. It does it very slowly and sneakily and before you know it, it has caught up with you. The asset you thought was good at 5% suddenly doesn’t look so good at 6%, or higher. Suddenly, people sit up and take notice of how ridiculous the valuations are on emerging markets (higher than developed markets, how did we not notice!); how high the stock based takeover prices seemed (again how did we not notice?) and how high all asset prices are suddenly – A $1m property in Newfoundland, just doesn’t seem like a bargain anymore when it rains there 50% of the time. And when one buyer hesitates, the rapid climb of prices stalls, and the next buyer becomes more unsure and so on. Everyone gets nervous. Like a chain reaction. We are just seeing the beginning now. Buckle your seatbelts. Expect risky stocks to correct as the price needs to be higher to pay for the risk. That includes: mining stocks, in particular speculative juniors (uranium, molybdenum, and nickel), emerging stocks, high P/E stocks and financial stocks. Guess what? Most of the Canadian market is at risk and is expected to continue correcting. Of course, we will see bounces and recoveries but don’t forget, risk is now more expensive.
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